One of my best trades in recent years has been to define a conscious time allocation for investing – specifically deciding how much time I should actively spend on trading and investment decisions.
It has always been one of the hardest things for me to balance staying in tune with the markets, while keeping enough distance to maintain the discipline and emotional detachment necessary for good investing. Resisting the pull of the screen has always been more difficult for me than to get going. My solution is to devote most of my investing time to research, writing and system development – and restrict myself to well defined screen time to make trading decisions.
The incredible opportunity of passive investing
Investing is the only cash generating opportunity I can think of where, with virtually zero skill and only an hour or two spent, one can earn very high returns on capital and savings thereby securing an independent retirement automatically, simply by setting it up and then … doing nothing.
To do this is simple, but it´s far from easy. The historical returns from a truly passive buy and hold investment across diversified global assets (9,5% per year from 1973 to 2015 before fees) are illustrated by the dotted blue line in the chart below.
Here is my recipe:
- Invest your capital and future savings in a diversified global asset allocation portfolio. You can buy a single ETF (e.g. GAA or others) or use a digital advisor, both of which allocate and rebalance your investments automatically. Low fees and tax efficiency are essential.
- Determine the necessary savings rate with a retirement calculator – if you have few other retirement vehicles in place, starting at saving 20% of your income is a good rule of thumb. You can dramatically influence the point in time when you will be financially independent by the percentage of your income you manage to save.
- Automate the monthly process of investing your savings, for example by automatic wire transfer to a Robo Advisor.
- Never look at it again – or at least as rarely as possible until you stop saving and start using your investment returns.
Most people, though, will let the opportunity passive investing offers pass them by. Realistically very few actually manage to grab it, but „forgotten“ portfolios frequently are the best long-term performers at major brokers. People, who are uninterested in their personal finance, just won´t implement a recipe like that, they consider it too risky and they are more likely to squander half their returns on fees in annuities, life insurance or similar „safe“ products, which will likely lead to a vastly inferior outcome.
Everyone with even a passing interest in his investments is unlikely to be able to keep himself from taking a peek and begin to meddle at the worst possible time.
The downside of becoming an active investor
Investing also has the unique characteristic, that increased activity and growing knowledge usually lead to deteriorating returns before superior performance is reached over time – if that ever happens. The misguided idea, that more activity equals higher returns, stems from the observation that this is true with most other financial activities and business ventures – the harder you work, the more you earn. It is rather astonishing just how much worse investment returns are likely to get by being actively involved – even with some knowledge.
The reasons, that a little bit of effort is unlikely to improve results, are the strong behavioral biases ingrained in all of us – our mental makeup is very unsuited to investing and overcoming this tendency takes a lot of hard work.
Even regularly checking your investment account will have that effect by introducing harmful behavior. Simply staying tuned into the investment world (which is very hard to avoid) will likely cause investors to increase risk at market tops and sell in panic at market bottoms, rather than simply holding and continue to dollar-cost average over time. This type of instinctive market timing causes distinct underperformance. And things are only likely to get worse with increased trading activity.
I have come to the strong conviction that becoming a successful active investor is an all or nothing decision – a little bit of effort does more harm than good. The time and effort required is similar to learning a musical instrument, becoming proficient at a foreign language or acquiring expertise in any new area. And why should it be any different? The motivation and competition in the field of investing and trading is very high. The difference to other fields (where you can estimate the time and cost in advance) is that the cost of tuition when learning to invest can be much higher than you bargained for.
The development of investment returns with increasing skill and activity
I try to quantify and show in detail what this may mean in practice in the following figure.
The green curve illustrates a typical path from passive investor to active investor to active trader to skilled investor/trader over time, showing long-term average returns for each stage. The graph is distilled from my personal experience, stories told by other investors / traders and academic studies. It is a stylized illustration – real experience varies with different market environments, through the influence of luck and from investor to investor, but tends to follow a common path in most cases.
The Behavior Gap between passive and active investors
What is the result of looking at our portfolio moderately frequently and keeping track of current news? We are bound to take action at the wrong time and our returns are very likely to deteriorate through performance chasing, panic selling and a host of other mistakes ingrained in us. Several studies have quantified the difference in return between the market (that a truly passive investor would earn) and the average real investor – called the Behavior Gap – which amounts to a whopping 2,75% underperformance on average across all studies or earning almost 30% less than the historical return:
The digital advisor Betterment has a good article (including the table above) on their website that illustrates this Behavior Gap – they are touting their own services (they are leading the industry in the positive implementation of behavioral psychology, in my opinion), but the advantages of automation and behavior counseling hold true for other digital and many human advisors.
I think, it is possible to bridge the behavioral gap and to use behavioral market inefficiencies to our advantage – after all consistent underperformance by a large number of market participants does imply the possibility of outperformance in a zero-sum game for those who manage to do that. But it is a long journey and we will always retain the instinctive tendencies, fed by fear and greed, that lead to the performance gap in the first place. It takes constant conscious effort to stay on top of it.
A good opportunity to take a shortcut across the bottom part of the green curve does exist: By concentrating our efforts on learning as much as we can about long-term investing we might avoid the realm of short-term active trading altogether and our performance curve may just take a much shallower dip. It is also quite manageable with some effort – most successful investors can be found in this area of the market.
The lure of outsized profits is hard to resist, though – however unrealistic it might be. Just think of cryptocurrencies, day-trading myths etc. and the incredible promise of independence and freedom it entails…
Suffice to say, that I would have been glad to have taken the shortcut, but unfortunately I didn’t and followed the green curve down the rabbit hole of consistent losses – just like most active traders.
The low percentage of successful active traders
One particular study in the table above stands out: Barber and Odean from the University of California not only looked at average underperformance, but put it into the context of investor´s trading activity. Higher levels of investing activity led to 6,50% underperformance – by far the highest level in all studies quoted in the table with the most active investors earning 68% less than historical returns!
Barber and Odean didn’t stop there, they specifically began looking at the most active group of traders, namely day traders, and came to the shocking conclusion that only 2% displayed consistent profitability and
“Less than 1% of the day trader population is able to predictably and reliably earn positive abnormal returns net of fees.“
Sources for retail trader´s performance are notoriously hard to find, but all the material I read looks pretty dismal. Even the most optimistic source doesn’t put success rates above 20% – I judge the most often quoted number, that 95% of very active traders lose money, to be a trustworthy average of several sources.
Overconfidence in their own abilities is the main reason plenty of people enter the fray against all odds – the most skilled 1% will gladly take everybody else´s money and an entire industry lives from the enormous transaction fees these traders generate. On top of that countless products and services are being peddled to active traders. While it seems to be a profitable business selling the idea of active trading, trying to make a living from short-term trading isn´t an endeavor blessed with a high probability of success.
Somewhere at the bottom of the green line in the graph above plenty of beginning traders suffer from a blow-up of their account, many of them giving up for good. Virtually all successful trader´s stories feature an account of pulling through that phase, learning from the mistakes made and struggling on towards success. It is a very difficult and often frustrating process, because outcomes vary greatly from month to month and year to year – alternating between exhilarating highs, when everything seems possible, and depressing lows.
How to pull through the bottom and become consistently profitable
I am convinced that progressing further must involve an individual paradigm change. As there are many different approaches to the market that work for different people, this means finding the right approach including the right level of activity in the market for one´s personality.
My personal paradigm change involved taking a step back from active trading and to concentrate on finding sustainable sources of return as a base for long-term investing – implementing a rules-based approach derived from sound investment principles with plenty of academic research and examples of successful practical implementation behind them. A key feature has been the combination of valid ideas from different investing philosophies and strategies. And the simple recipe from above – buying and holding a global asset allocation ETF – has become one cornerstone of my portfolio.
Going down that path has led me back to profitability and – in time – back to select active strategies, which I describe in this blog. All my active approaches are based on highly probable, strong (but often not part of the mainstream) return sources in the market.
My shortest active time frame spans two weeks (and this is in a strategy that diversifies across different time frames), but most of my systematic strategies are more medium- and long-term in nature and anything shorter than two weeks, I consider random noise. I restrict my active trading time to half an hour a day with an extra weekly hour for medium- and long-term strategies. I never was very attracted to watch prices blink on a screen for hours on end and I don´t think it is productive. But I do spend much more time researching and writing about investing and that´s what I love about it – it´s just immensely interesting to me no matter the excess return I generate. This approach currently gives me the most value for my time.
Professionals skim most of the cream – or not?
While I agree that most of the excess returns generated through active investing will go first to transaction fees and second to professionals, I think individual investors, who professionalize their approach, have a distinct advantage because they are highly unconstrained and can concentrate on what works best for them.
Professional money managers don´t actually have an incentive or better chance at beating the market, which is the reason why they usually don´t. Beating the market makes it necessary to be different from the market and being different also means that there will be times when the manager underperforms. As a rule every outperforming strategy must face the risk of severe underperformance or its constant excess return would quickly be arbitraged away – the market is very efficient in that regard. Career risk gives the manager the incentive to avoid underperformance at all cost, implying that he will much rather perform in-line with the market than outperform one year only to be out of a job the next when he underperforms (even if cumulatively he managed to beat the market).
If an individual investor can stand it psychologically to look very different from his peers in good and bad times, he has a great possibility to use that to his advantage.